Monday, November 28, 2011

In
recent days, the world's bond market has been repeatedly shocked and awed by
the very rapid rise in both long and short-term interest rates in several
European countries. Investors are demanding higher returns because they
perceive an increase in risk, particularly in debt issued by Italy, Greece and
Spain among others and now even France and Germany are feeling the sting of
investor anxiety.

As
Mr. Bernanke and his fellow bankers at the Federal Reserve have made quite
clear, they wish to maintain an ultra-low interest rate environment for the
foreseeable future. I'm certain that their European counterparts wished
the same thing, however, sometimes the market dictates what direction interest
rates will move in rather than accepting the official rates posted by the Fed
and their pals at other central banks around the world. In light of the
rather rapid move upward in European sovereign bond interest rates, I thought
that it would be interesting to see what would happen if the United States
suddenly found itself caught in the bond market squeeze and how higher interest
rates would impact the ability of Congress to reach the ever elusive and never achieved
goal of fiscal balance.

For
your illumination, here are 10 year bond interest charts for France:

...Spain:

...and
Italy:

Notice
how in each case, there was a long period of relatively low and stable interest
rates prior to the sharp recent rise in yields. Just long enough to lull both bond traders and governments into thinking that everything was just fine.

Now,
let's take a look at the government's books to October 31, 2011 as found on the TreasuryDirect
website. Here is a screen capture showing the summary of Treasury
Securities:

Notice
that of the $9.75 trillion in marketable securities, the vast majority is in
the form of Treasury notes (maturities between one and ten years) which make up
$6.5 trillion of the total. The remainder of the marketable debt is
composed of Treasury Bills (up to roughly one year maturity) totalling $1.48
trillion, followed by Treasury Bonds (maturities between twenty and thirty
years) totalling $1.03 trillion and TIPS (Inflation Protected Securities)
totalling $715 billion. The debt also includes a nonmarketable component,
the vast majority of which consists of $4.72 trillion worth of
intragovernmental holdings along with savings bonds that are not traded in a
bond marketplace. Intragovernmental debt is a rather sneaky form of debt;
it is incurred when government borrows from federal trust funds such as the
Medicare Trust Fund and the Social Security Trust Fund to help fund everyday
operations. Just think of it as robbing Peter (American taxpayers) to pay
Paul (those in Washington). At the end of October 2011, the total
combination of marketable and nonmarketable debt reached $14.994 trillion.

Now
let's look at how much interest was paid in the last fiscal year on that debt:

Now,
let's break down Washington's current marketable debt into its constituent parts and look at the
range of interest rates paid on each component and its average:

Here's a chart showing the average interest rate
on marketable debt, non-marketable debt and the average interest rate on the
combination of the two and by how much the interest owing on the debt has
changed on a year-over-year basis:

To
summarize, effective at the end of fiscal 2011, the average interest rate on
$15 trillion of both marketable and nonmarketable debt was 2.859 percent.

For
fun, let's look back at the October (since that is the end of Washington's
fiscal year) average interest rate data back to the year 2000 and graph the
data:

Notice
how the average interest rate on the debt has generally declined since the turn
of the millenium and how the interest rate in 2011 is at a decade-long low. As
well, the average interest rate for the decade is 4.539 percent, once again,
the interest rate in 2011 is only 63 percent of the long-term average.

Now,
let's go back to the debt. As I noted above, the most up-to-date debt
figure for the debt was November 23, 2011 and the debt on that day stood at
$15.036 trillion. Now, let's multiply that by the average interest rate
on the debt for 2011 (2.859 percent) along with other interest rates ranging up
to 7 percent to see just how rapidly things could go very, very wrong. Here
is a graph showing the results:

You
must remember one thing. I am holding the level of the debt constant
when, in fact, it is growing by billions every day, making my calculations a
best-case scenario. As well, notice that the 7 percent interest rate
seems stratospherically high by today's standards but it is less than one half
percent below the rate back in 2000. Let's put these interest totals into
context. If we look at Washington's final tally for fiscal 2011, the budget deficit was $1.299
trillion for the year. Receipts from individual income tax reached $1.091
trillion, just above my calculated total interest owing on the debt should the
average interest rate on the debt reach 7 percent. So much for those
fantasies of fiscal balance.

Now,
let's take the 12 year average interest rate on the entire debt of 4.539
percent and elevate the debt in trillion dollar jumps and see how the interest
owing on the debt rises as Washington incurs increasing levels of debt:

With
a historically accurate 12 year average interest rate of 4.539 percent, the
interest owing on the debt rises by $45.39 billion for each $1 trillion
increase in the level of the debt. By the time Washington's debt reaches
$22 trillion, the interest owing on the debt at the above noted level will
nearly reach the trillion mark and, as I noted above, would consume all of the
2011 revenue from individual taxes.

I'm
not going to go through the entire exercise, but if the debt reaches $20
trillion (a most achievable goal; should Washington continue to accumulate debt
at $1.3 trillion annually, the $20 trillion mark will be reached in 3 years and
10 months) and average interest rates on the debt reach a still modest 6
percent, the annual interest on the debt will be $1 trillion. This is
basically what Washington spent on Medicare and Social Security in fiscal 2011.

Some
time back, a reader asked me to see if I could provide a method for balancing
the budget. Here is ModeratePoli's attempt to balance Washington's budget,
a most interesting effort. I thought rather than repeating ModeratePoli's
exercise, I'd rather take a look at the achievability of fiscal balance from
the existing debt side of the equation. From the calculations that I've
completed for this posting, my gut instinct is that Washington will never
achieve fiscal balance, largely because the debt is already too large. We
are entering a phase where structural deficits will be a permanent annual
fixture; no matter how much the economy grows, spending will always be more
than revenue, largely because of one factor - interest owing on the debt. Right
now, Washington is in the fortunate, once-in-a-lifetime situation of having two
factors working in its favour; first, a prolonged period of ultra-low interest
rates and second, the fact that Treasuries are regarded by the world's bond
markets as the investment of last resort. What is particularly
frightening is that these two factors are completely out of their control. Should
the world's bond traders decide that the United States no longer deserves the
status of the world's reserve currency, things could get very ugly, very fast. Just
ask Europe. They know.

9 comments:

You are correct, we are past the point of no return, but not mathematically...only politically. If our politicians had the gumption to end The Afgan war and downsize the military, legalize and tax drugs and prostitution, institute a VAT and a sur charge on very high incomes, and reform entitlements, this mess could be corrected...but you are right, it won't happen.

I disagree that we are past the tipping point. When I look behind the numbers on interest rates, I see that there is a lot of money sloshing around the world, and we're big enough and transparent enough to attract a lot of that money. At least for now. I think we have a little more time before we hit the tipping point.

At least this year we're going in the right direction. Last December's deal extending the Bush tax cuts and adding on some goodies was a miserable failure for our deficit.

One reason I'm optimistic is that, as Carl pointed out, we have many items in our budget we could cut, and sources of income we could tap if we need to and have the will to. Just think how much money we could save if we allowed (or enforced) some reasonably conservative decision-making on medical procedures.

I don't know if we'll have the political will to make these adjustments in time. I'm going to try to be part of the solution, not one of those saying it's impossible.

Lastly, thanks for the plug for my budget, though I jumped in shock when I saw it. Luckily, I wasn't holding anything sharp or liquid, so I survived.

Thanks for both of your comments (and glad that ModeratePoli survived the shock - hope you didn't mind my linking to your blog). I guess one of the reasons that I'm pessimistic is that I think we have reached the tipping point for tax increases with the only hope being that any change is completely transparent and the playing field is levelled. I look at the uprisings in many nations when heavily indebted governments try to change taxes even modestly and how often increases are reversed. On the cutting side, it's a similar philosophy to the NIMBY idea; cut any program....as long as I don't need it or don't like it!

From my observation, governments often waste the first part of their mandate when they have the political horsepower to effect meaningful change on either spending or taxing and then cannot make changes later on when they are afraid that they will lose the power they so badly seem to need.

Let's hope that I'm wrong, although, I'd be more encouraged if there was some sign from governments that they intended to reduce the level of debt some years down the road. Otherwise, as I posted, it is the growing interest owing on the growing debt that is going to be the biggest problem with achieving balance.

APJ:Intragovernmental debt is a very sneaky (and maybe snarky) type of debt.Unlike debt held by the public, interest "credited" to the trust funds incurs no budget expense.And, the current interest rate credited to the trust funds is 4.1%!This credited interest is paid with additional debt, and as you said, the trust fund surplus is used to pay current expensdes and lower the deficits (even though every penny of interest and principal in over 230 trust funds is phantom principal and interest, being accessed only from tapping general revenues, lowering expenses, etc. (the same way we pay all government expenses, with or without a trust fund).See a paper entitled Financial Audit Bureau of the Public Debt's Fiscal Years 2011 and 2010 Schedule of Federal Debt," issued by the GAO.In particular, look at pages 2-3, 13, 17, 21, 25, 26,and 27.http://www.gao.gov/new.items/d12164.pdf.Don Levit

@PJ, Link as much as you want. I respect your analysis a great deal, and you have 10x the traffic. I haven't had this many visits since I insulted... er... criticized Ron Paul 3 months ago. By the way, you handle disagreement much better than Ron Paul supporters, that's for sure.

@ APJ.....very interesting article. In fact, it's damn scary when you think of what could happen. Makes me want to grab my beef jerky and bottled water and head for the hills. I hate to say it, but the political climate in the states is such that they don't have the wherewithal to deal with these issues. It makes your scenario above a more likely outcome if Washington doesn't get its house in order.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.